Running a small business can be rewarding, but at times, it can be the source of headaches – especially when dealing with customers who don’t pay for the goods and services you’ve already provided them with. You are going to have to adjust your financial records for these bad debt write-offs, and if you maintain your books and records in accordance with generally accepted accounting principles, or GAAP, you’ll need to understand how the allowance method works for uncollectible business revenue.

Allowance Method Entries

As the name implies, writing off bad debts requires the creation of an “allowance for doubtful accounts” account to reflect a reasonable estimate of your company’s accounts receivable balance that won’t be collected. Creating the allowance account allows you to write off a bad debt expense immediately without having to analyze every customer account first. The allowance is a contra-asset account, meaning its balance should be treated as an offset to another asset -- which in this case is accounts receivable. Once an allowance estimate is established, a debit entry is made to the “bad debts expense” account and a credit entry for the same amount is made to the allowance account.

Percentage of Accounts Receivable

There are two acceptable methods to estimate the balance of your allowance account. Commonly, accountants and business owners estimate using a percentage of the year-end accounts receivable balance. This is accomplished by assigning different percentages to various portions of the balance based on the number of days payment is past due as reported in an aging receivables report. For example, historical financial data may indicate that approximately 1 percent of balances that are past due 30 days or less won’t be collected, while 5 percent of balances between 31 and 60 days past due are uncollectable. Therefore, if $1,000 of receivables are 30 days or less past due and another $1,000 are past due between 31 and 60 days, you can estimate an allowance of $60. However, if there’s already a $10 balance in the receivables account, for example, only $50 of the $60 estimate should be added since the goal is to report an ending balance of $60.

Percentage of Sales

An alternative approach, which may be relevant to businesses that sell goods, is to estimate the allowance account using a percentage of credit sales. The appropriate percentage to use also can be based on historical collections data for the company, or if a relatively new venture, an average that’s reflective of the industry standard can be used. However, unlike the percentage of receivables method, the estimate can increase the allowance balance regardless of whether the account has a positive balance remaining from a recent credit sales analysis.

Financial Statement Effects

Using the allowance method for write-offs and taking an immediate bad debt expense ultimately reduces the net profit reported on a company’s income statement. The allowance account, however, is reflected on the company’s balance sheet and is combined with the accounts receivable balance to report a net receivable amount. As specific customer accounts are charged off, adjustments are then made to the allowance and receivables accounts only, though the net receivables balance will never change.

References

About the Author

Jeff Franco's professional writing career began in 2010. With expertise in federal taxation, law and accounting, he has published articles in various online publications. Franco holds a Master of Business Administration in accounting and a Master of Science in taxation from Fordham University. He also holds a Juris Doctor from Brooklyn Law School.